Financial Market Freak Out

That guy on CNBC is screaming (louder than usual). Financial markets are in "turmoil" and the Fed is "injecting liquidity into the system."

What is the Fed actually doing? The federal funds rate is the interest rate at which banks borrow reserves from each other - its what's called an "interbank" rate because supply and demand both come from banks. Increasing concerns about credit quality have led to a spike in demand for reserves and the Fed is using open market operations to increase the supply of reserves, thereby keeping the fed funds rate at (or at least close to) its target of 5.25%. Economist's View has a nice diagram and explanation. The Journal's Real Time Economics has a roundup of of worldwide central bank actions. As part of its action, the Fed accepted a large quantity of mortgage-backed securities as collateral for repurchase agreements - somewhat unusual, as Economist's View explains.

So, what is this "liquidity" everyone's talking about? According to the glossary in Mankiw's intermediate macro text, "liquid" means "readily convertible into the medium of exchange; easily used to make transactions." Markets for some financial assets, particularly ones associated with mortgages, have completely dried up. That is, they have become "illiquid" - and that makes it hard to know their value since there's no price. One of the events that set off the latest tizzy was the announcement that BNP Paribas suspended withdrawals from several of its funds, citing lack of liquidity. According to the Bloomberg story BNP Paribas said: "The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating." Its far from clear that the Fed's actions will directly affect this problem; people seem to be using the word "liquidity" rather loosely these days.

I do wonder if the "liquidity" story may be somewhat self-serving; surely there are some funds out there willing to scoop up mortgage-backed poop if the discount is big enough. Isn't that what hedge funds are for? Or is "buy low, sell high" too simple a strategy for them?

How unusual is this "crisis"? One typical element of financial disturbances is a "flight to quality" as panicky investors sell risky assets and buy "safe" ones like US Treasury bonds - this results in rising spreads (the extra yield over Treasuries) for low-rated corporate bonds and bonds from "emerging market" countries. Even though nothing's changed about the creditworthiness of, say, Brazil, they will have to pay a higher interest rate today than a month ago because of the mood swing in the markets. Reuters has a useful chart of how much spreads (the difference in bond yields over treasuries) have widened in previous crises. So far, this one's not a biggie.

Have the changes in the financial system made things different this time? Take a look at the analysis of the NY Times' Floyd Norris, who compares the current situation to banking panics of the past. The Washington Post's Steven Pearlstein is critical of the new financial order.

But, for all the sturm and drang, is this really bad news for the economy? Its too soon to tell - serious financial crises in 1998 and 1987 did not lead to recessions. Offhand, I can think of three risks to the real economy: (i) a prolonged credit crunch could be harmful for investment (that is, purchases of capital goods by firms) (ii) if things get really bad in housing markets, people may reduce their consumption and (iii) if the fed overreacts it could lead to inflation and/or new asset bubbles. On the last point, I think Bernanke can be trusted much more than Greenspan.

Update: At Econbrowser, James Hamilton has more explanation of what was going on in the federal funds market.
Update #2: At VoxEU, Stephen Cecchetti has a FAQ on the Fed's actions.